DBRS Limited (DBRS Morningstar) upgraded the Issuer Rating and Senior Unsecured Debt rating of Sobeys Inc. (Sobeys or the Company) to BBB from BBB (low) and changed all trends to Stable from Positive. The rating upgrades reflect the ongoing improvement in Sobeys’ business risk profile through efficiency/profitability gains as well as the strengthening of its position as Canada’s second-largest nationally diversified grocer through the expansion of FreshCo and Voila and the successful integration of Farm Boy and Longo’s. Furthermore, the upgrades and Stable trends reflect DBRS Morningstar’s expectation that Sobeys’ will be able to maintain its credit metrics at a level appropriate for a BBB rating on a normalized and sustained basis.
On February 10, 2022, DBRS Morningstar changed the trend on Sobeys’ ratings to Positive from Stable. At that time, DBRS Morningstar stated that, should Sobeys continue to deliver operating performance in line with DBRS Morningstar’s expectations while maintaining relatively stable credit metrics, an upgrade of the ratings to BBB could occur over the course of the next year.
Since then, Sobeys has reported results for the third quarter ended January 29, 2022 (Q3 F2022) as well as the fourth quarter ended May 7, 2022 (Q4 F2022). Same-store sales declined -1.7% and -2.5% during Q3 and Q4 F2022, respectively, in the context of the economic reopening. That said, the combined revenues during these two quarters (H2 F2022) still increased 9.2% year-over-year (YOY), resulting in revenues for the full-year F2022 to grow modestly ahead of DBRS Morningstar’s forecast expectations to $30.2 billion from $28.3 billion in F2021. Revenue growth in F2022 was driven by a 53rd week, as well as the acquisition of Longo’s, higher fuel sales, and new store openings, including the expansions of Farm Boy in Ontario and FreshCo in Western Canada, along with the expansion of Voila in Ontario. EBITDA margins were stronger than expected in F2022, declining only 7 basis points (bps) to 7.2%, following a 61 bps margin expansion in F2021. Cost saving and efficiency improvement initiatives related to Project Horizon, inflation-driven price increase, and lower Coronavirus Disease (COVID-19)-related health and safety expenses were more than offset by operating deleverage, growth in fuel sales, and front-loaded costs related to the expansions of Farm Boy, Voila, and FreshCo as well as inflation-driven pressures on input cost and wages. As such, EBITDA in H2 F2022 grew ahead of DBRS Morningstar’s expectations, resulting in EBITDA for the full-year F2022 to increase to $2.17 billion from $2.06 billion in F2021.
Sobeys continued to generate a meaningful level of free cash flow (FCF, before changes in working capital and lease principal payments) of $462 million, despite significantly higher dividends and capital expenditures (capex), which primarily related to store improvements, banner conversions, and new store openings, as well as infrastructure and technology investments, during F2022. The Company primarily used its FCF, in combination with cash on hand, for lease principal payments and the acquisition of Longo’s. DBRS Morningstar notes that, subsequent to the end of F2022, the Company repaid $500 million of notes that were originally due in August F2023 with cash on hand. As such, pro forma the $500 million notes repayment and despite an almost $400 million increase in lease liabilities during F2022, key credit metrics strengthened meaningfully during the period, with debt-to-EBITDA improving to 3.18 times (x) from 3.41x at the end of F2021.
DBRS Morningstar believes that Sobeys’ earnings profile will continue to improve within the context of the new rating category over the near to medium term, considering the benefits of Project Horizon and notwithstanding some near-term headwinds related to volumes moderating from their elevated pandemic levels and inflationary pressures as a result of input costs and wage increases. Project Horizon is tracking in line with management's expectations and is forecast to deliver $500 million in annualized EBITDA and improve the Company’s EBITDA margins by 100 bps by the end of F2023 through growth in market share and cost saving and efficiency improvement initiatives. DBRS Morningstar forecasts same-store sales growth to stabilize in the low single digits in F2023, benefiting from inflation-driven price increases and despite the further normalization of consumer buying behavior following the pandemic. Combined with the continuation of the aforementioned expansions, DBRS Morningstar expects revenues to grow to approximately $30.5 billion in F2023, despite the lapping of the 53rd week, and to above $31.0 billion in F2024. DBRS Morningstar anticipates that Sobeys’ EBITDA margins will expand in F2023 and F2024, with the benefits from merchandising initiatives related to Project Horizon and inflation driven price increases, offsetting front-loaded costs associated with the roll-out of Voila, and store remodeling efforts, including the FreshCo conversions, as well as inflationary pressures on input costs and wages. As such, DBRS Morningstar forecasts EBITDA to grow to above $2.20 billion in F2023 and to increase to above $2.40 billion in F2024.
In terms of the Company’s financial profile, DBRS Morningstar forecasts Sobeys’ financial leverage to modestly increase temporarily as operating lease liabilities, including additional lease liabilities associated with the addition of the third Voila customer fulfilment center in Calgary, continue to grow, but expects credit metrics to remain appropriate for the new BBB rating and further strengthen over time in line with earnings growth. Based on forecast operating cash flows of approximately $1.8 billion, capex of approximately $800 million, and annualized dividend payments of above $500 million, DBRS Morningstar forecasts Sobeys’ FCF (before changes in working capital and lease principal payments) to be above $400 million in F2023 and grow in line with earnings in F2024. DBRS Morningstar expects the Company to use its FCF primarily for lease principal payments. As such, DBRS Morningstar forecasts Sobey’s credit metrics to remain appropriate for the new BBB rating (i.e., debt-to-EBITDA below 3.50x) on a normalized and sustained basis. DBRS Morningstar could take a positive rating action should Sobeys’ business risk profile materially strengthen and credit metrics improve, such that debt-to-EBITDA drops below 2.5x on a normalized and sustainable basis as a result of growth in operating income.
ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS
There were no Environmental/Social/Governance factor(s) that had a significant or relevant effect on the credit analysis.
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.
All figures are in Canadian dollars unless otherwise noted.
The principal methodology is Rating Companies in the Merchandising Industry (July 26, 2021; https://www.dbrsmorningstar.com/research/382073) and DBRS Morningstar Criteria: Guarantees and Other Forms of Support (April 4, 2022; https://www.dbrsmorningstar.com/research/394683), which can be found on dbrsmorningstar.com under Methodologies & Criteria. Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (May 17, 2022; https://www.dbrsmorningstar.com/research/396929).
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The rated entity or its related entities did participate in the rating process for this rating action. DBRS Morningstar had access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.
The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. DBRS Morningstar trends and ratings are under regular surveillance.
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